NetEase Offers Value In China’s Gaming Market Amid Uncertainty (NASDAQ:NTES)

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Introduction

NetEase (NASDAQ:NTES) is the second-largest gaming company in China, a country that holds the title of the largest gaming market in the world with more than 600 million players. Despite the limitations imposed by the Chinese government for playing video games, NetEase still managed to grow in 2022. However, is it a good investment opportunity? I think so, but only if bought below its intrinsic value, given the uncertainty surrounding the Chinese gaming industry.

Business Model

NetEase’s business model is based on developing and licensing mobile and PC games for the Chinese market. In this segment, mobile games account for 70% of revenues, following the gaming industry trend which sees mobile games as the prevalent category among others.

Revenues are generated through in-game purchases of items, points, and avatars. Most games are offered to the Chinese market, but the company is expanding to international markets like Japan, where it succeeded with Knives Out, and the USA and Europe where it acquired game developer companies.

The other two main segments consist of learning services, under the Youdao subsidiary, and Cloud Music, a streaming music company owned by NetEase. Youdao, with more than 110 million MAU, offers translation tools, online courses, smart devices to improve learning capabilities, and digital solutions to enhance education.

Cloud Music, with 182 million MAU, offers streaming music services under a subscription program and live-streaming events for music content which generate revenues from the sales of virtual items purchased by users during the live stream. The remaining segment comprises so-called “innovative Businesses” such as Yanxuan, an e-commerce platform, NetEase News, and NetEase Mail.

Gaming is definitely the major driver of NetEase’s revenues, accounting for 72%, followed by Innovative business at 15%, Cloud Music at 7%, and Youdao at 6%. But as regards margin contribution, the gaming sector is the only contributor.

Growth Drivers

The main growth drivers are represented by R&D expenses, in which NetEase has to keep investing to develop new game titles and in-game functionalities to attract more users, and by the purchase of intangible assets, which refers to the purchase of content and licenses to introduce video games developed by other companies in the Chinese market like the exclusive license agreed with Microsoft to distribute Minecraft in China.

Knowing how much and how well NetEase has invested in its growth drivers in the past, we are able to calculate the expected growth rates of NetEase’s future revenues. To calculate it, we need the Reinvestment Margin, which shows what percentage of revenues has been reinvested into the company, and the Sales to Invested Capital ratio, which shows how much revenue has been generated for each dollar invested by the company.

By multiplying these two values and taking the median value over the years, we obtain the expected growth rate, which in this case equals 13%.

Operating Performance

Briefly looking at its past performances, from 2011 to 2021, NetEase’s revenues grew at a compound annual growth rate (CAGR) of 28%, reaching $13.7 billion in 2021. The company’s median operating margin and the return on invested capital (ROIC) have also been impressive, at 20% and 13%, respectively. However, these metrics have been on a declining trend in the past five years.

Despite this, free cash flows to the firm (FCFF) have grown from $500 million in 2011 to $2.6 billion in 2022. In the nine months ended so far, revenues grew by 8.7% in USD terms, and the operating margin was 21%.

From a financial perspective, NetEase has a negative cash position of -$1.5 billion, but of the $4 billion in debt, $3.5 billion are short-term borrowings, which are more than covered by the company’s short-term investments of $13 billion. The company’s current ratio, debt-to-equity ratio, and interest coverage ratio are all strong indicators of financial stability, with values of 2.31, 0.26, and 85, respectively. This suggests that the company is financially solid.

Projections

I use the discounted cash flow analysis method to value NetEase. The aim of a DCF analysis is to determine the present value of expected cash flows generated by the company in the future.

The first step is to project the growth rate at which revenues will grow in the future. Secondly, we will need to assume the degree of efficiency and profitability at which the company will turn revenues into cash flows.

Efficiency is represented by the operating margin, and profitability by the ROIC. Having the revenue projections and future operating margins, we obtain the EBIT and, after subtracting taxes, we get the net operating profit after taxes. The ROIC is used to determine the reinvestments needed to support future growth, determining how much profit the company generates from every dollar reinvested into the company. Future cash flows are calculated by subtracting the reinvestments from the net operating profit after taxes. The higher the growth rate, the higher the reinvestments needed to support it, hence the lower future cash flows will be.

The last step of a DCF analysis is to apply the discount rate to future cash flows, usually calculated using the weighted average cost of capital (WACC).

In order to project the company’s future performance, analysts have estimated that revenues will be in the range of $14.3 billion in 2022. For the following years, we can apply the expected growth rate of 13%, based on the company’s past investments in growth drivers, and expect this rate to gradually decline as the company reaches maturity. This would result in revenues of around $27 billion by 2031, doubling in ten years at a CAGR of 7%.

In terms of future efficiency and profitability, considering the declining trend seen in recent years and have made conservative assumptions. I expect the operating margin and ROIC to remain stable around their median values in the coming years. Comparing NetEase to Tencent (OTCPK:TCEHY), the leading company in the Chinese gaming industry, Tencent has a median operating margin and ROIC of 26% and 14.5%, respectively. Based on this comparison, I expect NetEase to reach similar values as it reaches maturity in 2031, with an operating margin of 23% and an ROIC of 15%.

With these assumptions, I estimate the FCFF to be around $3.5 billion by 2031, after subtracting the reinvestments needed to support growth from the operating income after taxes.

Applying a discount rate of 8.3%, calculated using the WACC, I deduce the present value of these cash flows to be $47 billion, or $74 per share.

Risks

While China is the largest gaming market by revenue with more than 660 million gamers, and the e-sports market there is the most developed in the world, the Chinese government has issued a series of restrictions to reduce the risk of developing gaming addiction among young people.

In August 2021, the National Press and Publication Association, the government body responsible for approving video games before they can be introduced to the Chinese market, restricted playing online video games only during weekends and national holidays, and for a total of only three hours during that period, for all youth under 18 years old.

Beyond time constraints, spending capabilities have also been reduced for underage gamers, further harming the gaming industry. For NetEase, this means that the company may face challenges in attracting and retaining a younger user base.

Other than imposing restrictions, the National Press and Publication Association, stopped approving video games for 9 months from July 2021 to April 2022. Among the gaming companies hit the most, NetEase and Tencent didn’t see any approval for more than a year.

Conclusion

In my opinion, at today’s prices, NetEase appears to be fairly priced. However, when considering the company’s short-term investments worth $13 billion in the calculation of the equity value, its intrinsic share value jumps to $96, indicating that NetEase may still be undervalued today. However, the uncertain regulatory environment and potential limitations imposed by the Chinese government on the gaming industry present a significant risk for investors.

In conclusion, NetEase has a strong business model and has delivered solid results over the years. However, in order to achieve great returns, it is crucial for the restrictions imposed by the Chinese government on the gaming industry to be removed. Based on my analysis, NetEase may represent a good investment opportunity if purchased below its intrinsic value, as a precautionary measure against any further negative developments in the Chinese gaming industry.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.